Managing Tax and Exchange Control in China

When doing business in China, it is important to consider how you will be paid, and get the payment out of the country.  Not only must a company manage taxes, they must also manage exchange control. 

Exchange control in China greatly favors payment for imported goods and discourages the payment for services performed outside China.  It also creates administrative hurdles to payment of licenses and dividends.  For this reason, for example, capturing payment through the sale of goods, or copyrighted material might be greatly more efficient than licensing the use of the material. 

China’s unique foreign exchange control regime.

China operates a foreign exchange control system – funds which flow in and out of China are monitored by the State Administration of Foreign Exchange (SAFE).

When the Chinese licensee makes a royalty payment at the bank, the bank requires a list of documents on behalf of SAFE to verify whether the transaction is genuine and reasonable. Failing to provide any of the required documents, will result in the bank not executing the payment. Although the requirements on foreign exchange control are public, the practices of different banks, in different locations and at different times may vary significantly. In recent years when China’s foreign currency reserves dropped continuously, SAFE tightened the restrictions on the flow of funds going out of the country.    

For example, the list of documents for outbound payment of patent/technology royalties includes “technology import contract registration certificate” issued by a provincial commerce authority and tax payment certificates (for withholding income tax, VAT and surtaxes) against the royalties (these two issues are elaborated on below). The lack of a registration document could halt the payment.

Why is it difficult to register the licensing agreement?

Import or export contracts for technologies must be registered with the Commission of Commerce for statistical purposes. But there are no legal consequences if the parties choose not to do so.

However, as banks sometimes require the registration of the document to progress the payment.

There can be many complexities.  For example, the registration of the contract could be unsuccessful for different reasons. If the licensee is a university or other organization not incorporated as a company, it is not qualified to be an applicant for registration through the government’s online system. Therefore, an agent specialized in import and export of technology should be included as a third party to the licensing agreement.  However, this causes concerns for the licensor because of confidentiality and control risks.

While the registration is not a pre-condition for the effectiveness of the licensing agreement, the government official reviewing the agreement during registration could “suggest” a change to certain clauses, such as the governing law to be Chinese.  Not following the advice could lead to the failure of getting the registration done.

Be careful about what you call it

A big frustration caused to a foreign licensor closing a deal or even after deal signing is that China taxes at a rate of 16% have to be taken. The Foreign licensor then discovers, for a cross-border transaction, a withholding of income tax (usually 10%), VAT (6%) and surtaxes (on top of VAT) are applicable and the licensor is legally liable for them. The licensor will find itself in a very awkward and unfavorable position to renegotiate to negate the impact. The VAT may be exempted, but it lies with the licensee to take steps to make a successful application with the tax authority. Sometimes the licensor may negotiate down the VAT, as the licensee could utilize it as future credit.  But withholding tax will be difficult, since the licensor may claim it as foreign tax credit in its home country theoretically.

Selling goods is more efficient Selling goods or copyrighted material will attract less tax and less exchange control.  That is because a good being imported is not treated as a revenue stream to the non-Chinese seller, unlike a royalty payment.